We’re on the road to a global debt jubilee – that’s if we’re lucky
Normal market mechanisms have been suspended as the world grapples with the coronavirus crisis. John Stepek looks at where this is all likely to end.
Happy Easter weekend – hope you enjoyed the sunshine yesterday (assuming it was sunny wherever you are).
Quick thing before we start – if you haven’t already subscribed to MoneyWeek, act now. You not only get your first six issues free, but we’ll throw in a copy of my new ebook, The Little Book of Big Crashes. It’s rammed with information about some of the biggest (as well as some of the most obscure) market crashes in history, and there are plenty of details that are pertinent to today. So sign up now!
And on that note, I wanted to have a look at what history suggests might happen next after this crisis is past its acute phase.
How 2008 paved the road for the reaction to the 2020 crisis
In the foreword to my new book on historical market crashes (free when you subscribe to MoneyWeek), I flag up three main points that booms and busts tend to have in common. The most important is that “the seeds of the next crisis are sown during the last.” In other words, the actions we take to bail us out of the current crisis will give rise to the next.
It’s very clear to me that the coronavirus crisis is giving us a textbook example of this.
In 2008, the global financial system was successfully prevented from melting down. But it was done in a very messy manner. “Temporary” measures such as quantitative easing became permanent. The system became dependent on constant intervention from central banks in order to continue to function.
And what with the US Federal Reserve being the most important central bank in the world, the world became even more dependent on the US monetary system. When we talk about the lack of liquidity in markets, what that fundamentally means is that your ability to access free-flowing cash when push comes to shove, is dependent on just how close you are to the Fed’s fire hose.
You need only look at the stockmarket performance of banking systems across the globe since the 2008 crash to understand that this is true. Several US banks have seen their share prices recapture the glory days and surpass them. That’s not true of any other banking system.
OK, so what legacy has that left for us? It meant that any future crisis (regardless of whether it was caused by a bog standard recession, a geopolitical event, or what we actually ended up with – a pandemic) was always going to have to involve the government getting even more involved in the economy.
Ultimately, you can’t have the central bank making decisions on who and what to bail out at such a granular level without the illusion of independence being stripped away. These are decisions that require democratic accountability of some sort and with the market mechanism no longer able (or allowed) to provide that accountability, the responsibility has to return to government.
And that is exactly what’s been happening.
The illusion of central bank independence has been put aside
In the UK, the Bank of England has made it very clear that the government can lean on it to provide financing at any point at which it requires it. The government is in charge. Independence is a convenient fig leaf, but when there’s an emergency, it gets tossed aside.
In case that metaphor is putting you off your breakfast, I will move swiftly on.
We’re seeing the same thing happen in the US right now. At the end of last week, the Federal Reserve made an even more monumental intervention in markets. A Bloomberg piece by Brian Chappatta summed it up in a headline: “Fed is seizing control of entire US bond market”.
The Fed is now able to do the following: it can buy municipal bonds. In other words, it can prop up the finances of states and even local councils (to put it into language that makes it a bit clearer for UK readers).
It can also buy junk bonds. To be fair, not just any junk bonds. But it is now able to buy “fallen angels”. Falling angels – as I’ve mentioned in several Money Mornings in the last year – were seen as the big faultline in the corporate debt market.
A fallen angel is a company whose debt was investment grade at one point, but has now been downgraded to junk. That’s a bad position to be in because it creates a whole load of forced sellers. Some investors (big funds usually) simply aren’t allowed to own such debt.
The risk until now has been that credit quality has collapsed in recent years because companies are so indebted at a time when anyone with money has been desperate to lend to them. So quality control standards have slipped badly.
As a result, more corporate debt than ever before has been sitting on the boundary line between investment grade and junk. The risk was that a slide in ratings could create a whole raft of extra junk debt that no one wanted to buy, thus driving up borrowing costs for companies and forcing more of them to the wall.
Now the Fed has said that it will buy the junk debt of any companies who were rated investment grade as of 22 March. In other words, if you get written down due to the coronavirus hit, the Fed will jump in and prop up your debt.
On this news, junk bonds – which had been lagging their investment grade cousins during the rally – soared. And not only this, the Fed can now buy collateralised loan obligations too – effectively giving aid to private equity firms, even although they’re all meant to be sitting on trillions of dollars of “dry powder”.
“We had to destroy free markets to save them”
This is like 2008 on steroids. And as John Authers puts it, also on Bloomberg, this means that “markets are rising on another Faustian bargain”.
The point of free financial markets – the only point of such markets – is to enable capital to be allocated to people who are going to use it in such a way that it generates more capital.
In other words, you want scarce resources to go to the people who are going to make the most productive use of them. In turn, this is how we grow the whole pie. Growing the whole pie is how you get society to buy into capitalism, because for all its faults and its terminal lack of “cuddliness”, they can see that it beats the alternative, which sounds cuddly but tends to end up in the gulag.
How can we tell that allocation is working? Because companies that succeed make money, because their products or services are so useful that they end up being in great demand. Companies that don’t succeed go bankrupt, and the resources that they were using ineffectively are recycled to people who can make better use of them.
Competition and reinvention. Those are the benefits of free markets and they are embodied in rising productivity.
If you suspend the market mechanism – if you make credit available to just about anyone who is big enough to shout for help to the Fed – then you suspend competition. Not only that, but you pile even more crushing pressure onto those who are not big enough to benefit from a direct government lifeline. That suffocates competition.
It also means that you break the social contract. Capitalism and free markets without bankruptcy are simply kleptocracies – money for cronies. And people won’t put up with that. That’s why the next step is bailouts for all (via helicopter money). And that ends up with economic sclerosis plus inflation.
I increasingly think that the best hope now is for a one-off debt jubilee (where in effect, we just cancel everyone’s debt). It sounds radical (it is, but less so than you might think) but you reset the system once, then return to the old rules. Resources are drawn to the people who make the best use of them for the public good, and we all benefit as a result.
Unfortunately, I can’t see it happening that cleanly. I hope I’m wrong.
Anyway – we’ll be following up on what all of this might mean for investors (the return of inflation, in particular, is a big issue we’ll be paying lots of attention to) in MoneyWeek magazine over the coming year. To get your first six issues free – plus the Little Book of Big Crashes – subscribe today.